Ratio Analysis
A Ratio gives the mathematical relation ship between one variable and another. Ratio analysis helps in valuing the firm in quantitative terms. Ratios are classified as follows Liquidity Ratios Ownership Ratios o Earnings Ratios o Leverage Ratios Capital Structure Ratios Coverage Ratios Dividend Ratios
1)
Liquidity Ratios:
Liquidity implies firms ability to pay its debts in short run This ability can be measured by Liquidity Ratios Current Ratio and Quick Ratio are the two ratios which directly measure Liquidity Receivables turnover Ratio n Inventory Turnover Ratio are the two ratios which in directly measure Liquidity I. Current ratio = Current assets . Current Liabilities Current assets which are converted into cash within one year Current liabilities are liabilities which are to be repaid within a period of 1 year. Current Assets Current Liabilities Cash Loans And Advances Marketable Securities Trade Creditors Debtors O.S.Expenses Inventories Provisions Loans and Advances Pre Received incomes Prepaid Expenses O.S.Incomes
IDEAL RATIO = 2:1 II. Quick ratio or Acid Test ratio = Quick Asset Quick liability = Current Assets Inventories- Prepaid expenses . Current Liabilities Bank O.D. Income Received in Advance Ratio of quick assets to quick liabilities. Quick assets which can be converted into cash very quickly. Quick liabilities are liabilities which have to be necessarily paid with in 1 year. Ideal ratio 1 <1 is considered as inadequate liability of the business. III. Absolute Liquid Ratio = Absolute Liquid Assets Current Liabilities Ratio of quick Absolute liquid assets to current liabilities. Absolute liquid Assets = Cash + Bank + Short Term Investments. Ideal Ratio = 1:2 or 0.5 IV. Bank Finance to working Capital Gap ratio = Short Term Bank Borrowings Working Capital Gap Working Capital Gap = Current Assets Current Liabilities It Shows the firms Reliance on short term bank finance for financing the working capital gap
2 Relation ship between debtors and sales Ideal Ratio 10 - 12 2. Average collection period or Debt Collection Period = No. of Days in a year Debtors Turn over Ratio No. of days it takes for the debtors to get converted in to cash. Ideal Ratio 30-36 days High Debtors turn over ratio or low debt collection period indicates sound credit management policy. 3. Inventory Turnover Ratio = Cost of goods Sold Average Inventory It indicates no. of times stock has been turned into sales in a year Ideal Ratio = 8 Cost of goods sold = Sales gross profit Average Inventory = Opening Stock + Closing Stock 2 Stock Conversion Period = Cost of goods Sold * NO. of days in a year Average Inventory 4. Creditors Turn over ratio = Net Credit Purchases. Average Creditors Average Creditors = Opening Creditors + Closing Creditors 2 Relation ship between Creditors and Purchases Ideal Ratio 12 or More 5. Average Payment period or Debt Payment Period = No. of Days in a year Creditors Turn over Ratio No. of days Taken by the business to pay off its debts Ideal Ratio 30 or less Low Creditors turn over ratio or High debt Payment period indicates sound credit management policy.
2)
These Ratios measure the efficiency of forms activities and its ability to generate profits. Two Types of profitability ratios
A. Profits in relation to sales: These Ratios identify the sources of the business efficiency Gross Profit Margin Ratio = Gross Profit Net Sales Gross Profit = Sales Cost Of goods sold Net Sales = Sales Sales Return - Excise Duty There Is no Ideal Ratio Higher the ratio better will be the performance of the business. Net Profit Margin Ratio = Net Profit Net Sales It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. It shows the result of overall operation of the firm.
Ability to generate a large volume of sales on a small asst base is an important part of firms profit picture.
Improperly used assets increase the firms need for costly financing. Earning Power = EBIT . Average total assets is a measure of operating Profitability is a measure of operating business performance which is not effected by interest charges and tax payments Return on Equity = Net Income . Average Equity Net income = PAT ( Profit after Tax) is an important profit indicator to share holders of the firm.
3) Ownership ratios:
a. Earning Ratios b. Leverage Ratios i. Capital Structure Ratios ii. Coverage Ratios c. Dividend Ratios
EPS is the net profit after tax which is earned on the capital representative of one equity share. Higher the EPS, better the performance of the company.
EPS IT gives the relation ship between market price of the stock and its earnings by revealing how earnings affect the market price of the firms stock. P/E Ratio has Practical application in forecasting the market price of a share. There is no ideal ratio
Equity
= Long Term Liabilities + Current Liabilities Share Holders Funds Ratio 2 or Less Exposes Its Creditors Lesser Risk Ratio >2 Exposes Its Creditors Higher Risk
ii.
Measure Financial Risk: Debt Ratio High - Higher Risk Debt Ratio Low Lower Risk
Debt + Lease + Loan Repayment + Preference Interest Rent Installment . Dividend . (1 Tax Rate ) (1 Tax Rate )
iii.
Indicates whether Business is Earning Sufficient Profits to pay not only interest but also installments of personal amount.
C. Dividend Ratios:
i. ii.